The Fed's healthy fear of deflation

Federal Reserve Chairman Ben Bernanke speaks during a news conference at the Federal Reserve in Washington, Wednesday, Sept. 18, 2013. The Federal Reserve has decided against reducing its stimulus for the U.S. economy because its outlook for growth has dimmed in the past three months. The Fed said it will continue to buy $85 billion a month in bonds while it awaits conclusive evidence that the economy is strengthening.(AP Photo/Susan Walsh)
— AP

Federal Reserve Chairman Ben Bernanke speaks during a news conference at the Federal Reserve in Washington, Wednesday, Sept. 18, 2013. The Federal Reserve has decided against reducing its stimulus for the U.S. economy because its outlook for growth has dimmed in the past three months. The Fed said it will continue to buy $85 billion a month in bonds while it awaits conclusive evidence that the economy is strengthening.(AP Photo/Susan Walsh)
/ AP

Unemployment has fallen to 7.3 percent, not the 7 percent threshold Bernanke articulated in May, let alone his 6.5 percent goal. And that modest decline isn’t nearly as healthy as it might otherwise appear.

“Long-term unemployment and underemployment remain high,” the Fed chairman said in his prepared statement. “And we have seen ongoing declines in labor force participation, which likely reflects discouragement on the part of many potential workers, as well as longer-term influences such as the aging of the population.”

As for financial conditions, interest rates have lingered at higher levels since Bernanke unveiled the Fed’s plan to gradually wean the economy off stimulus.

This has raised borrowing costs and probably cut purchases of cars and houses, as well as deterring some businesses from investing in expansion. Partly because of tighter credit conditions, the Fed lowered its forecast of overall economic growth to between 2 percent and 2.3 percent for all of 2013, from a June forecast of 2.3 percent to 2.6 percent.

In comments Wednesday, Bernanke also worried that a budget standoff in Washington over the debt ceiling could rattle markets in the fourth quarter. Autopilot cuts to some federal spending will reduce U.S. economic output by 1 percent to 1.5 percent this year, according to an estimate by the Congressional Budget Office.

Yet this laundry list describes a lackluster economic recovery, not the kind of impending doom that explains massive stimulus. Until, that is, you add in the inflation numbers, which are scary.

Economic theory predicts that five years of unprecedented stimulus should have caused major inflation by now. But the 2 percent level the Fed considers healthy has been elusive.

Bernanke, who is an expert on the history of the Great Depression, was deeply worried during the 2008 financial crisis that falling inflation would give way to deflation, a spiral in which generally falling prices cause consumers to delay purchases in hopes of even lower prices, which depresses prices — and wages — further.

Last month, inflation dipped below 1 percent by one measure and 1.5 percent by the Fed’s preferred measure. Household income has been falling since 2006, although this may have hit bottom last year, according to fresh Census estimates.

Economists know that too much monetary stimulus can inflate asset bubbles, like tech stocks in the 1990s and real estate in the 2000s, and perhaps bonds today. The pain of popping bubbles is well understood.

But nobody really knows how to stop a deflationary cycle. That’s the great unknown driving the Fed’s stimulus policy today.